Retirement Accounts in Divorce
The following is an excerpt from Women, Divorce and Money: Taking Control of Your Finances and Your Future, by David Stolz. Available on Amazon.
A common marital asset that is divided in divorce is a retirement account (or multiple retirement accounts). These can be a confusing bucket of acronyms and code section references like IRAs, SEP-IRAs, ROTH IRAs, 401(k), 403(b), 457(b), and so on. Confusing—yes, but retirement accounts can be very important, as if one or both of you have been working for a long time, you may have significant amounts of money in them, sometimes in the millions of dollars.
First, let’s separate retirement accounts into defined benefit plans and defined contribution plans. As the name suggests, a defined benefit plan defines the “benefit” that you will receive at retirement. So, it might say that you will receive a benefit of $1,000 per month for your life at retirement, or it might say you will receive 25 percent of your ending salary for the rest of your life, and so on. Sometimes called pension plans, these are less common, but if you have one, they can be a very nice asset to have for your retirement. You will need a valuation expert to determine the value of a defined benefit plan, as they need to consider your age, life expectancy, the amount you will receive each month, and so on. An expert in valuing a pension plan might say that a plan that pays $1,000 per month at age 65 for life is worth $126,982 today. The valuation of a pension plan by one expert may not be the same as a valuation by another expert, as each one might have used different assumptions in their computations. If the plan allows for it to be split, would you rather have half of $126,982 now or $500 a month at your retirement for life? Have your financial planner help you with this but consider taking the $500 per month at retirement, as receiving a payment for life can be a nice complement to your other investments.
A defined contribution plan, on the other hand, defines the “contribution” that goes into the plan and does NOT guarantee any benefit at retirement. With defined contribution plans, you can reduce your salary and put the money into the retirement account, and your employer may add money to the account also. A defined contribution plan is easy to value as the money is in an investment account, so you can look up the value at any time. These plans include 401(k)s, 403(b)s, and others.
Let’s say you have agreed to divide your retirement accounts equally between the two of you, how do you accomplish this? How do you call up your retirement plan people and ask them to split the account in two? You may have already heard a new term called a “Qualified Domestic Relations Order,” or “QDRO” (pronounced quad-row). QDROs are complicated, confusing, misunderstood, and completely necessary. The term is misused at times, but the short version is that a “qualified” retirement plan requires a QDRO to instruct the retirement people how to split the accounts. A “non-qualified” retirement account, like an IRA, only requires the instructions to be in your divorce settlement agreement. You send a copy of your divorce agreement to your IRA custodian, and they will divide the IRA as per the agreement. A QDRO, on the other hand, has its own special tax code section that defines what it is, and very stringent requirements that must be met, or else you risk some potential bad tax problems. One bad thing about losing a case in tax court is that your name is associated with your mistake forever. In Hawkins v. Commissioner, poor Mr. Hawkins gave his wife $1,000,000 from his qualified retirement plan, as they had agreed to in their divorce settlement. A few days after he gave her the money, he tried to prepare a QDRO—oops, you can’t do it in that order. The tax court said the entire $1,000,000 was taxable to him as a distribution when it should not have been taxable at all! Ouch. Your attorney will know whether your retirement accounts are qualified or not, and if a QDRO is required. Typical “qualified” plans include pensions (not all pension plans can be divided) and defined contribution plans like 401(k)s. “Non-qualified” plans include IRAs (Traditional, ROTH, and rollover) and SEP-IRAs. Some attorneys don’t like to prepare QDROs, so they hire a QDRO specialist to do it. Just make sure that one of the attorneys (typically the one whose client is receiving the money) will take the responsibility to prepare it.
One planning tip is that if you are dividing a retirement account with a QDRO, you have the opportunity to take some of the money out of the account without any early distribution penalty that would otherwise apply if you were under age 59½. So your QDRO could say that you will receive $500,000 from your STB-x’s 401(k), and you want $50,000 distributed to you in cash and the remainder will go to a new IRA account in your name. You would still pay the income tax on the $50,000, but not the normal 10 percent early distribution penalty that would apply if you were under age 59½. If you deposited the full $500,000 into your IRA and the next day distributed $50,000 to yourself, you would have to pay income tax AND the 10 percent penalty. It must be done as part of the QDRO. This can be a good way to free up some cash at the time the account is divided. Since an IRA is not a qualified plan, this won’t work with an IRA.
For divorcing couples looking for investment options or looking to set up a solo 401(k) plan after splitting up, Stolz & Associates, P.S. is available to help. We specialize in helping high-net-worth and ultra-high-net-worth individuals who are saving for retirement manage their funds, so give us a call today if you are looking for financial assistance, regardless of your marital status.